The IRS on Nov. 30 issued proposed regulations and frequently asked questions on the new Medicare taxes scheduled to take effect in 2013. The Medicare taxes were enacted as part of the 2010 health care reform legislation and comprise two parts:

  • a 0.9% "additional Medicare tax" on the individual share of earned income above $200,000 (single) or $250,000 (joint), and
  • a new 3.8% tax on "net investment income" to the extent modified adjusted gross income (AGI) exceeds $200,000 (single) or $250,000 (joint).

The proposed regulations on the additional Medicare tax (REG-130074-11) provide fairly straightforward guidance on employer withholding and individual reporting on tax returns. They are generally proposed to be effective when published, but may be relied upon now.

The proposed regulations on the new 3.8% tax (REG-130507) are expansive and provide guidance in many areas, but are also complex and leave some areas of uncertainty. They are proposed to be effective in 2014, but taxpayers may rely on them in 2013.

Additional Medicare tax

The regulations require employers to generally withhold an additional 0.9% Medicare tax (in addition to the current 1.45% tax on employees and employers) on any wages paid to an individual in excess of $200,000 in a calendar year, without regard to an individual's filing status or any wages from another employer. The IRS will add a line to Form 941 for employers to report this additional Medicare tax, and the existing line for regular Medicare tax on other wages will remain unchanged. Employers do not need to segregate Medicare tax deposits in the electronic federal tax payment system (EFTPS).

Individuals will calculate the additional Medicare tax on their income tax return. Those who won't satisfy their liability through normal withholding must either make estimated tax payments or request additional income tax withholding using Form W-4.

The additional Medicare tax also applies to self-employment income, and taxpayers will need to account for it in their estimated tax payments.

Tax on net investment income

The new 3.8% tax on net investment income applies to the following types of income to the extent modified AGI exceeds $200,000 (single) or $250,000 (joint):

  • Rents, royalties, interest and dividends unless derived in the ordinary course of a trade or business that is not a passive activity to the taxpayer and is not a trade or business of trading in financial instruments
  • Capital gain from dispositions of property unless held in a trade or business that is not a passive activity to the taxpayer and is not a trade or business of trading in financial instruments or commodities
  • Income from a trade or business that is a passive activity to the taxpayer or is a trade or business of trading in financial instruments or commodities

The tax will not apply to self-employment income or qualified retirement plan distributions, though qualified retirement distributions can increase modified AGI and therefore result in more overall income subject to the tax. Gain or loss from the disposition of an active interest in a partnership or S corporation that is not in the trade or business of trading in financial instruments or commodities will be taken into account only to the extent gain or loss would have been taken into account if all the assets of the business were sold.

The proposed regulations provide important clarity in several areas:

  • Liability for the 3.8% Medicare tax will be subject to all estimated tax provisions and penalties.
  • The IRS will use the definition of "trade or business" in Section 162 for purposes of the exceptions to the tax.
  • The IRS will use the rules in Section 469 to determine whether an activity is passive.
  • Taxpayers will be allowed a "fresh start" to group activities in order to determine material participation under Section 469.
  • The IRS will not provide guidance on what is considered "derived" or "held" in an ordinary course of business, instead relying on existing case law and guidance.
  • Passive loss carry-forwards, but not net operating losses, can be taken against net investment income for purposes of the tax.
  • Deferral and income inclusion provisions in other areas of the code will generally be respected for purposes of the Medicare tax.
  • Tax on dispositions of an S corporation or partnership interest will be determined with a deemed asset sale.

These and other issues are discussed in more detail in the following.

Income from pass-throughs

To avoid the 3.8% tax on income passed through from a sole proprietorship, S corporation or partnership, the income must be "derived in the ordinary course of a trade or business" that is not a passive activity to the taxpayer (or be gain from property "held" in a nonpassive trade or business). The exception does not apply to any income from a business of trading in financial instruments or commodities.

  • Trade or business — The proposed regulations incorporate the definition of "trade or business" in Section 162(a), but do not provide guidance on what is considered "derived" or "held" in the ordinary course of business. The IRS is instead relying on existing case law (Lilly v. Commissioner 343 U.S. 90, 93) and similar rules outlined in Treas. Reg. Sec. 1.469-2T(c)(3)(ii).
  • Portfolio income — The regulations provide that portfolio income is not considered to be derived in the ordinary course of a trade or business and that income from working capital is specifically included in the calculation of net investment income.
  • Passive activities — The IRS will use the passive activity rules under Section 469 to determine whether taxpayers have an active interest in a trade or business. To be active under Section 469, taxpayers must meet one of seven tests in Treas. Reg. Sec. 1.469-5T(a) to prove material participation. Real estate activities are subject to special rules, and limited partners in a limited partnership can use only three of the seven tests.
  • Groupings — IRS regulations under Treas. Reg. Sec. 1.469-4 allow taxpayers to group activities for purposes of the material participation tests. Taxpayers generally cannot regroup activities in future years, but the proposed regulations give taxpayers a "fresh start" to regroup activities in either the taxable year beginning in 2013 or 2014.
  • Recharacterization — There are special rules in the Section 469 regulations that recharacterize income from certain passive activities as nonpassive income. These will generally not apply for the 3.8% tax and include the special rules on:
    • rental of nondepreciable property,
    • significant participation,
    • net interest from passive equity-financed lending activities,
    • property rented to a nonpassive activity, and
    • acquisitions of interest in a pass-through engaged in licensing intangible property.

Trading in financial instruments or commodities

The determination of whether an entity is in the trade or business of trading in financial instruments or commodities is made at the entity level. For the income to be considered derived from trading in financial instruments or commodities, the income must be derived from an activity that would be considered trading under Chapter 1. This is a question of fact relying on existing case law.

The proposed regulations define financial instrument to include stocks and other equity interests, evidence of indebtedness, options, forward or futures contracts, notional principal contracts, any other derivatives or any evidence of an interest in any of the listed items. The term "commodities" is defined statutorily using the definition in Section 475(e)(2).

Dispositions of pass-through interests

Gain from the disposition of an interest in a partnership or S corporation is taken into account only for purposes of the 3.8% tax to the extent net gain would be taken into account if all the property were sold at fair market value.

The regulations state that this is calculated using a deemed asset sale. Gain or loss is determined by comparing the fair market value of each property with its adjusted basis, and it is then allocated to the taxpayer. If the property is held in a trade or business in which the taxpayer materially participates (and it's not a business of trading in securities or commodities), no tax is due on the hypothetical gain. The regulations provide that the determination of whether the property is held in a trade or business is made on a property-by-property basis.

The proposed regulations state that gain from a cash distribution in excess of a taxpayer's adjusted basis in S corporation stock or a partnership interest is treated as gain from the disposition of the stock or partnership interest. But the IRS requested comments on how to determine a partner's interest in Section 1411 assets upon such a distribution.

Deductions and inclusions

Deferral and income inclusion provisions in other areas of the code will generally be respected for purposes of the Medicare tax.

  • Deductions — Deductions that can reduce net investment income include investment interest, taxes on investment income, investment income expenses and carry-forwards for passive activity losses, capital losses and investment interest. Deductions will be subject to the same limitations as they are for income taxes (such as the 2% AGI floor for miscellaneous itemized deductions or the overall limit on itemized deductions), and the amount and timing are determined using the normal rules for income taxes. Net operating losses will not reduce net investment income, but can reduce modified AGI.
  • Deferral — Gain not recognized under other provisions of the code — including installment sales under Section 453, like-kind exchanges under Section 1031, involuntary conversions under Section 1033 and gain from the sale of a principal residence excluded under Section 121— will generally not be considered gain for purposes of the 3.8% tax.
  • Income — Tax-exempt interest is not included in net investment income but substitute interest or substitute dividend in securities lending or sale-repurchase is.

Estates and trusts

Estates and trusts are generally be subject to the 3.8% tax on undistributed net investment income to the extent their adjusted gross income is in the highest tax bracket ($11,650 in 2012).

Several types of trusts not subject to income tax are not subject to the 3.8% tax, including charitable trusts, qualified retirement plan trusts, grantor trusts and charitable remainder trusts. Income from a grantor trust that is taken on the grantor's return is subject to tax if applicable.

Next steps

Although taxpayers may rely on the regulations in 2013, the regulations are currently only in proposed form, and the IRS is soliciting comments on many areas of uncertainty — particularly pass-throughs and the interaction with self-employment taxes. The rules are very complex, and the IRS makes clear in its preamble that it will closely review transactions it perceives as intended to avoid tax and will challenge them based on applicable statutes and judicial doctrines such as substance over form. Please contact Grant Thornton LLP to discuss your specific situation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.